Why the “Miracle of Compound Interest” leads to Financial Crises
Oslo conference, “Financial Crises in Capitalism”, Aug. 27, 2007
By Dr. Michael Hudson
I first met Erik Reinert in 1994 at an economic history conference in Germany, and have been a member of his Reality Economics group since its founding.
Erik Reinert’s Reality Economics group has revived the awareness of economists whose names have disappeared from most histories of economic thought, even as many schools have dropped courses in that topic itself. Most students only are taught today’s mainstream orthodoxy, not being informed of the equally long history of another canon – one that turns out to be more helpful in explaining economic history and today’s dynamics.
Looking at today’s global economy, the obvious question to ask is why more economies haven’t achieved the technological potential reached by North America and Europe. Given the fact that technology is fairly universal, why aren’t all nations operating up to this potential?
Most of the papers produced by the working group here in Oslo have emphasized increasing returns and the technological basis for comparative advantage. Reviving the 19th-century writings of German and American national economists, Reinert and his colleagues have reviewed the arguments why latecomers may require protective tariffs, subsidies and public infrastructure investment to catch up, especially in the spheres of education and public health. Increasing returns tend to widen the competitive advantage of leading industrial nations (whose agriculture has achieved equally remarkable productivity gains by being industrialized into agribusiness). The effect is to render labor, capital and technology in the less developed periphery obsolete, under-educated and under-supplied with public infrastructure. The result is a chronic trade and payments deficit, building up over time to impose a heavy foreign-debt burden.
The technological core of economies is wrapped in a framework of property laws, financial practices and taxes that vary sharply from one country to another. This institutional context imposes an extractive overhead of property claims and debt service that are largely a vestige of the conquest of Europe by the Vikings and their kin, who appropriated the public commons and levied property rents. These military conquerors were followed by the Templars and Italian bankers, who legitimized the charging of interest and standing royal war debts.
The financial counterpart to increasing returns in the production sector is the “magic of compound interest” – the tendency of debts to multiply by purely mathematical principles, independent of the “real” economy’s ability to pay. Early analysts of compound interest pointed out that the debt overhead tends to expand autonomously, eating into the “real” economy, slowing it down and polarizing property and income by diverting revenue away from production and consumption to pay creditors.
What distinguishes the “other canon” from today’s dominant orthodoxy is its rejection of the assumption that economies tend to stabilize automatically in a fair and equitable balance, and hence do not require government regulation – and that public enterprises operate more efficiently if transferred into private hands. Accusing government planning of being inherently inefficient and hence needlessly costly, today’s self-proclaimed neoliberals claim that the dynamics of free markets will overpower whatever government planners try to impose.
Defending the need for active public policy, the other canon finds that such a balance requires that markets be shaped by selective taxation, public regulation, subsidies and infrastructure investment. Privatization of public enterprises and other parts of the public domain adds to their cost of production by building in financial charges and capital gains by owners, and higher payments to the financial managers who end up as planners of these assets.
According to this approach, the slogan of “free markets” is merely a euphemism for centralizing planning power in the hands of financial and other vested interests that are seeking to break away (that is, “free”) of oversight, regulation and taxation by elected officials. They seek above all to make central banks independent – that is, controlled by the commercial banking interest – and to concentrate trade and tax policy in the hands of the IMF and World Bank globally, and domestically in an Executive Branch controlled by financial and property lobbyists. Thanks largely to the privatization of election financing and its rising media advertising costs in today’s political campaigns, the vested property and financial interests have succeeded in un-taxing and deregulating themselves. This is just the opposite policy from that advocated by the classical liberal political economists from Adam Smith through John Stuart Mill. To these “original” liberals, a free market meant a market free of free lunches for the rentier interests. Their idea of freedom was one of equal opportunity for all economic players.
It is important to recognize that every economy is planned. Forward planning began in the Neolithic to schedule the planting and harvesting of crops, as well as sea and caravan trade and the festivals that organized the community’s basic rhythms. The calendar emerged as the major planning vehicle, usually kept by sky-chiefs. In today’s world, corporations plan how much to produce for the market, how much advertising can create a demand for their products and build brand loyalty, and where to focus research and development spending. Their lobbyists ask governments to invest in infrastructure, grant subsidies, price supports and tax concessions (“loopholes”), rezone land sites, regulate foreign trade and provide police protection against fraud and other crime. Consumers plan how much to allocate for education and save for retirement, how long to stay in school, and seek regulation of workplace conditions, public health and related shaping of the economic context in which market forces operate.
Given the fact that all market participants engage in forward planning of one sort or another, the great political question concerns just who is to do the planning. To the extent that government relinquishes this role, planning passes into the hands of the economy’s financial managers. When the government steps aside, they pick up the slack. Unfortunately, their time frame is shorter and their aims are more narrowly self-serving than those of public officials. Most seriously of all, they seek the economic rent and extractive financial returns that classical liberals and Progressive-Era reformers sought to minimize by government regulation or taxation.
Today’s pattern of economic development and taxation is not what most 19th-century economists expected to see. Viewing economic evolution in terms of rising productive powers – and hence, living standards – they thought that economic management would pass naturally into the hands of industrial engineers under a regime of democratic parliamentary reform. They also expected governments to play a growing role, above all in by providing the infrastructure needed to make domestic industry and agriculture more competitive, and to prevent monopolies and other special interests from extracting rent or otherwise profiteering from the economy at large.
The classical economists characterized economic rent as “unearned income,” and John Stuart Mill called capital gains an “unearned increment,” best typified by the rising land values that accrued to landlords “in their sleep.” The aim was for prices to reflect only the returns to socially and technologically necessary costs of production, and to maintain an economy in which after-tax income is earned, not achieved by property privileges of special interests. Taxes levied on these rentier gains would be paid out of the economy’s “free lunch.” Rather than raising prices, taxing these returns keeps land values and the price of stocks in monopolies low.
To defend their moral and fiscal right to this income, and to minimize public regulation and taxation of price gains for land, stocks and bonds, the rentier interests depicted their returns not as extractive but as a bona fide cost of doing business, and hence earned. They even went so far as to claim that these returns acted as the mainspring of economic growth. On this basis the rentier lobbies in modern times have advocated that taxes should be levied on labor, not on the land’s economic rent or the extortionate prices and related gains demanded by monopolies.
In this paper I want to discuss the financial sector’s tendency to dominate, deflate and polarize economies, thwarting economic potential. Understanding these financial dynamics is essential to explain why all nations are not operating up to the technological potential toward which classical liberalism aimed, and why the world economy is polarizing, as are domestic economies even in the most advanced industrial nations.
The economics of compound interest
When I began to study the economic origins of modern civilization in the ancient Near East, I was struck by the degree to which the exercises taught to Babylonian scribal students c. 2000 BC were in some ways more realistic and even more mathematically sophisticated than the neoclassical models taught today. For starters, the rate of interest was expressed as a doubling time.A model Babylonian scribal exercise from circa 2000 BC, for instance, asks the student to calculate how long it will take for a mina of silver to double at the typical Mesopotamian rate for commercial loans, one shekel per mina per month – that is, 1/60th per month, 12/60ths per year – an amount equal to 20 percent in modern decimalized terms.[1] The answer is five years. This was the normal time period for backers to lend money to traders. (Assyrian loan contracts from about 1900 BC typically called for investors to advance 2 minas of gold, getting back 4 in five years.)
How long could the process go on at these rates? Another Babylonian scribal problem asks how long it will take for one mina to become 64, that is, 26. The solution involves calculating powers of 2 (22 = 4, 23 = 8 and so forth).[2] A mina multiplies fourfold in 10 years, eightfold in 15 years, sixteenfold in 20 years, and 64 times in 30 years, that is, in six five‑year doubling periods.
The idea is expressed in an Egyptian proverb: “If wealth is placed where it bears interest, it comes back to you redoubled”[3]. Another popular image compared making a loan to having a baby,[4] depicting the reproduction of numbers in sexual terms. What was “born” was the “baby” fraction of the principal, 1/60th, born with the new moon. Only when the accruals of interest had grown to be as large as their parent, after the fifth year, were they deemed “adult” enough begin having new interest “babies” on their own, for only adults can reproduce themselves. Compounding began only after the principal had reproduced itself – “matured” – after 60 months had passed.
The principle is familiar today in what accountants call the “Rule of 72”: To find the doubling time of a sum lent out at interest compounded annually, divide 72 by the rate of interest. A rate of 5 percent doubles the principal in just over 14 years (72/5 = 14.4). A 6 percent rate has a doubling time of 12 years; a 7 percent rate in 10 years. In 20 years the 7 percent loan will have redoubled, to four times the original sum; and in 30 years to eight times. This simple formula works for rates up to 20 percent, which happens to be the rate of interest charged when the practice first was developed in the third millennium BC in Sumer – what today is southern Iraq. The 20 percent rate was not reached in modern times until the U.S. economic crisis of 1980, as the prime rate commercial banks charged to their major customers.
These Babylonian examples are composed from the vantage point of lenders and investors, not debtors. There was no compounding of interest arrears. Investors who wanted to keep on multiplying their money had to find new borrowers and draw up new loan contracts in which to place their money to continue the compounding process. With the passage of time it must have become harder to find enough such opportunities, because economies do not grow exponentially over protracted periods of time, but in the S-curves that Carlota Perez’s paper describes, and which was known to Babylonian scribal students who were taught to calculate the growth of herds of animals in such complexity that the early translators thought that the numbers described actual practice. These exercises show an awareness that economic growth tended to taper off, not to speak of interruptions as a result of warfare, drought and flooding. The real-world economy was unable to keep up with the exponential growth rates projected in purely mathematical calculations of sums being placed at interest. The volume of trade could not keep on multiplying exponentially, and domestic lending opportunities also were limited.
Financial returns therefore probably accumulated in the hands of lenders more rapidly than they could find commercial opportunities. This phenomenon has proved fateful for lending in today’s capital markets to spill over to increasingly risky ventures. Antiquity’s laws said that merchants did not have to pay their backers if their ship was robbed by pirates or sunk, or if their caravan was robbed. Creditors thus shared in the risk of the merchants they financed (a practice that Islamic law revived). Near Eastern rulers resolved the tendency toward debt instability by annulling personal and agrarian debts when large numbers of cultivators were unable to pay as a result of flooding, drought or military disruption. This subordinated creditor claims to the economy’s ability to pay.
In the modern epoch, J. P. Morgan and John D. Rockefeller are reported to have called the principle of compound interest the Eighth Wonder of the World. The late 19th-century writer Michael Flürscheim described Napoleon as voicing a similar idea upon being shown an interest table and remarking: “The deadly facts herein lead me to wonder that this monster Interest has not devoured the whole human race.” Flürscheim commented: “It would have done so long ago if bankruptcy and revolution had not been counter-poisons.” And that is just the point, of course. Something must give when the mathematics of interest-bearing debt overwhelms the economy’s ability to pay. For awhile the growing debt burden may be met by selling off or forfeiting property to creditors, but an active public policy response is needed to save the economy’s land and natural resources, mines and public monopolies, physical capital and other productive assets from being lost to creditors.
To illustrate the dynamic at work, Flürscheim composed an allegory pitting the Spirit of Invention against the Demon of Interest and his offspring, Compound Interest, in a battle to see whose powers were stronger. The Spirit of Invention had an army of tools and machines, water power, air and wind power, fire and steam power to drive machinery. But Flürscheim asked whether its minions really would bring about a golden era, or whether this power could be conquered by finance capital and made to serve it by paying tribute rather than serving mankind in the form of higher living standards. To illustrate the principle at work he related a Persian proverb about a Shah who wanted to reward the inventor of chess, and asked what the man would like. The man asked “as his only reward that the Shah would give him a single grain of corn, which was to be put on the first square of the chess-board, and to be doubled on each successive square; which, to the surprise of the king, produced an amount larger than the treasures of his whole kingdom could buy” as the amount doubled on each of the board’s 64 squares.
For the first row of the board the amount of grain being measured out was modest: 1, 2, 4, 8, 16, 32, 64, 128 grains, reaching the power of 27 but still not even a cupful. By the second row, it became a large sackful: 215, or, 32,768 grains. It soon became obvious that to fill the entire 64 squares – eight rows – would 2123, far more than n the kingdom or, for that matter, the whole world possessed. The moral, Flürscheim concluded, was that in due course the mathematics of compound interest was “much more powerful than the Spirit of Invention,” ending up enslaving it.[5]
The political fight in nearly every economy for thousands of years has been over whose interests must be sacrificed in the face of the incompatibility between financial and economic expansion paths. Something has to give, and until quite recently creditors have lost. This is the point that modern economists and futurists fail to appreciate. Financial claims run ahead of the economy’s ability to produce and pay. Expectations that interest payments can keep on mounting up are “fictitious,” as Marx and other 19th-century critics put it. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.
Why isn’t this the starting point of modern economics? As Herbert Stein famously quipped: “Things that can’t go on forever, don’t.” The accrual of savings (that is, debts) is constrained by the economy’s inability to carry these debts. Recognizing that no society’s productive powers could long support interest-bearing debt growing at compound rates, Marx poked fun at Richard Price’s calculations in his Grundrisse notebooks (1973:842f.) incorporated into Capital (III:xxiv). “The good Price was simply dazzled by the enormous quantities resulting from geometrical progression of numbers. … he regards capital as a self‑acting thing, without any regard to the conditions of reproduction of labour, as a mere self‑increasing number,” subject to the growth formula: Surplus = Capital (1 + interest rate)n
Individuals found it difficult to make use of the compound interest principle in practice. Peter Thelluson, a wealthy Swiss merchant and banker who settled in London around 1750, set up a trust fund that was to reinvest its income for a hundred years and then be divided among his descendants. His £600,000 estate was estimated to yield £4500 per year at 7½ percent interest, producing a final value of £19,000,000, more than thirty times the original bequest.
Thelluson’s will was contested in litigation that lasted 62 years, from his death in 1797 to 1859. Under William Pitt the government calculated that at compound interest even as low as 4 percent, the trust would grow so enormous as to own the entire public debt by the time a century had elapsed. This prompted legislation known as Thelluson’s Act to be passed in 1800, limiting such trusts to just twenty‑one years’ duration. By the time all the lawyers were paid, “the property was found to be so much encroached on by legal expenses that the actual sum inherited was not much beyond the amount originally bequeathed by the testator.”[6]
But the savings of the living have continued to mount up. The banker Geoffrey Gardiner observes that in the late 1970s, “the burgeoning oil revenues of the producers were further gilded by the addition of high interest earnings. At their highest British interest rates had the effect of doubling the cash deposits of the oil-producers in only five years, or 16.3 times in twenty years! … The wisdom of an earlier age, which had led to the passing of ‘Thelluson’s Act’ to discourage the establishment of funds which compounded interest indefinitely, had been forgotten.”[7]
In his famous essay on usury, Francis Bacon observed: “Usury bringeth the treasure of a realm into few hands, for the usurer, being at certainties, and the other at uncertainties, in the end of the game most of the money will be in the box, and a State ever flourisheth where wealth is more equally spread.” The French socialist Proudhon echoed this basic principle in 1840, in his axiom that the financial “power of Accumulation is infinite, [yet] is exercised only over finite quantities.” “If men, living in equality, should grant to one of their number the exclusive right of property; and this sole proprietor should lend one hundred francs to the human race at compound interest, payable to his descendants twenty-four generations hence, – at the end of 600 years this sum of one hundred francs, at five per cent., would amount to 107,854,010,777,600 francs; two thousand six hundred and ninety-six times the capital of France (supposing her capital to be 40,000,000,000, or more than twenty times the value of the terrestrial globe!”[8] Hopes to increase human welfare through higher economic productivity would be stifled, Proudhon warned (in good St. Simonian fashion), if the self-expanding power of interest-bearing claims were not checked by policies to replace debt with equity investment.
The moral is that no matter how greatly technology might increase humanity’s productive powers, the revenue it produced would be absorbed and overtaken by the growth of debt multiplying at compound interest.
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